from Follow the Money

The United States, on sale

January 20, 2008

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The front page of the Sunday New York Times had a long article by Peter S. Goodman and Louise Story. But Maureen Dowd is a better barometer of the cultural zeitgeist that news page: today’s column skewers the Gulf’s purchases of US banks rather than the quirks and foibles of the Presidential candidates.

Both stories seem to have hit a nerve - they are the two most emailed articles in the Sunday Times.

The irony of government funds bailing out Wall Street titans formerly noted for their privatizing zeal is hard to miss. Wall Street now believes in (limited) government ownership. Too bad the Street has yet to come around to notion that fee income from managing other people’s money should be taxed like other fee income.

The other great irony, of course, its that "W"’s America has found that the investment funds of non-democratic governments offer easiest solution to the problems created by an under-capitalized American financial system. Selling the street to the Gulf (and Singapore) is a lot easier than bailing out the Street with taxpayer money. Talk about a change from the late 1990s, when US private companies graced magazine covers and Alan Greenspan warned about the dangers associated with a limited (US) government stake in the markets.

Dowd’s column - and for that matter Lex’s partial rebuttal of the FT’s earlier leader -- are a lot of fun. But the Goodman and Story should have more staying power. It highlights an important shift in how the US is financing its external deficit.

The collapse of demand for US asset backed securities (at least those without a n implicit government guarantee) has forced the US to finance its deficit by selling off its companies to foreign investors. The Thompson financial data that Goodman and Story highlight suggests that foreign acquisitions of US assets will double in 2007, rising from around $200b to $400b. For the first time since 2000, foreign acquisitions will top US acquisitions abroad, generating around $100b in net inflows. That is not enough to finance a $750b deficit, but every little bit helps.

Goodman and Story also make another important point: a lot of the 2007 inflows came from Europe and Canada, not Asia or the Gulf.

That is important, and not just because European and Canadian flows come from private investors. There is an enormous difference between foreign investment that is result of a process of economic adjustment, and foreign investment that results from a systematic effort to impede adjustment. The European and Canadian flows reflect the adjustment process; flows from Asia and the Gulf reflect government policy decisions to impede adjustment.

What precisely do I mean?

 

The dollar has fallen substantially against the euro, the pound and the Canadian dollar. That has made US goods cheaper relative to European and Canadian goods. It also has made US financial assets cheap, comparatively speaking. The result: financial inflows into the US and a falling US deficit with Europe and Canada. The cheap dollar is pulling in money, but it is also setting in motion a process that will lead to the elimination of the US balance of payments deficit with at least Europe.

This shows up most cleanly in say German investment in US factories - the ThyssenKrupp example in the Goodman and Story article, or German automobile firms’ decision to increase production in the US to hedge against dollar strength. This production will tend to displace European production, as European firms set up shop in the US to better serve the US market.

This was also a characteristic of the inflows from Japan in the 1980s. Japanese purchases of trophy US assets - most famously Rockefeller Center -- came after the yen had appreciated substantially against the dollar, making US assets seem cheap. It was part of the same process that led Japanese automobile firms to invest in US "transplants" - a process that actually led to a fall in the US deficit with Japan up until the Japanese bubble burst.

The story has a set of interrelated parts, but it starts with a change in the exchange rate. That makes the US an attractive location for private investment. It also tends to increase US exports relative to imports. And the adjustment in the trade accounts eventually reduces the US need to import funds from abroad. Large foreign purchases finance the transition to a smaller, more sustainable external deficit.

This incidentally was also true of US and European purchases in emerging Asia after the Asian crisis. The big exchange rate moves associated with the crisis - together with a collapse in investment - set in process an adjustment that reduced Asia’s need for ongoing inflows from abroad.

Inflows from China, the rest of reserve-accumulating Asia, Russia and the Gulf have a different character. They are the result of government policies that impede adjustment - whether policies that impede the appreciation of their currencies against the dollar or policies that avoid distributing the oil windfall to a country’s citizens.

As a result, the foreign assets pile up in government hands. Henny Sender gets this exactly right - all the money coming out of China right now is government money. Only China’s government is willing to take the risk that the dollar might fall as much against the RMB as it has already fallen against the euro.

True, the pace of increase in the US deficit with Asia has slowed, and it now looks to be falling slightly. But this adjustment is mostly cyclical. Once the US emerges from what now looks like a recession, barring more exchange rate adjustment, the US deficit with Asia should start to rise. And the US deficit with the oil-exporting world is still growing.*

The net result:

Government funds are the only large buyers of US assets in the world’s main surplus countries;

The government in question will likely take large losses on their investments, as they are taking currency risk that the market doesn’t want;

These flows aren’t part of a process that will eventually result in a set of changes that will bring the US deficit down. Rather they are a byproduct of policy choices to impede adjustment.

European private firms are investing in the US, precisely because it is now cheaper to produce in the US than in China. Chinese state firms are not investing in US plant and equipment. It is still cheaper to produce in China. Indeed, it isn’t at all clear to me that China’s government would ever be able (politically speaking) to invest in US facilities that compete with Chinese facilities, even if such investment made commercial sense. China’s government care more about Chinese jobs than commercial returns.

Back in the 1990s, a common vision of globalization was that the outward flow of capital from the US and Europe to the rapidly growing emerging world would provide new markets for US exports. That vision collapsed in the Asian crisis of 1997.

The new vision of globalization that emerged in the first part of the 2000s was quite different: globalization offered the US cheap imports and cheap bond financing, a combination that proponents argued offered big benefits to the US, even if it hurt workers who had to compete with cheap imports.

That vision is now coming under question: Chinese goods aren’t quite as cheap as they used to be, imported oil certainly isn’t cheap and the emerging world no longer seems all that inclined to accept US bonds in exchange for its exports.

The new, emerging vision of globalization taking shape in parts of Washington and New York is that globalization allows American entrepreneurs to create companies that the Street can help sell to sovereign funds in Asia and the Middle East to finance the US external deficit, to the benefit of all.

That vision is at least consistent with a set of recent trends. But my guess is that it will prove to be a hard (political) sale.

 

*I know all the pitfalls of looking at bilateral deficits. But here the bilateral data reflects the global data. Indeed, the global data tells the same story with even more force, as the rise in Asia’s surplus with Europe is propelling a rise in Asia’s overall surplus even if Asia’s surplus with the US is no longer growing.

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